The market rally needs to be on a firmer footing
Emerging market assets have soared this year on easy global liquidity, and the receding fears of synchronized interest rate hikes in the developed countries have further supported risk. Inflation has been low despite tightening labour market conditions in the US, Japan and Europe. Volatility has also been muted—though there has been the occasional geopolitical scare to provide jitters.
India has not been an exception. Investors in Indian financial assets have had a good run so far this year. The sharp decline in nominal economic growth, the weak growth in corporate earnings and balance sheet stress has not come in the way of a stock market rally that now seems frothy. However, valuations based on forward earnings are getting richer by the day—though perhaps not yet in bubble territory. The benchmark Nifty index had an average forward valuation of 15.86 over the past 10 years. The forward valuation right now is 20.35.
The combined data for foreign inflows into Indian financial assets hide the fact that far more money has been coming into the debt market rather than the equities market. Global equity investors have put a net $3.25 billion into Indian equities over the past six months. The comparable number for debt is $19.78 billion. The situation over the past three months is even starker. Equity investors have pulled out $1.64 billion while debt investors have poured in $7.03 billion.
The upshot: foreign interest in Indian financial assets is actually more in debt rather than in equity. The huge foreign interest in corporate bonds is welcome since it provides large companies a source of finance at a time when bank lending is very weak. However, there is a parallel macro worry that India is financing a large part of its growing current account deficit through debt rather than equity flows.
An even bigger source of liquidity is being provided by domestic retail investors through their growing participation in systematic investment plans. Underlying this trend are two important structural shifts in the structure of household savings. First, gross financial savings of Indian households were higher than gross physical savings in fiscal year 2016, for only the second time in 20 years. The previous instance was at the height of the great bull market that ended with the North Atlantic financial crisis.
Second, Indian households have been allocating a higher proportion of their financial savings to stocks and debentures. As the Mark To Market column published in this newspaper on Monday showed, households pumped in nearly a tenth of their financial assets in stocks and debentures in the fiscal year ended March, a huge jump from the 2.73% in the previous year. In fact, the proportion of household financial assets going into the capital markets is perhaps the highest ever.
Easy global liquidity conditions plus the structural shift in household allocations have helped power the steady rise of financial assets in recent months despite clouds on the economic horizon. Bullish analysts may argue that investors are patiently awaiting the inevitable economic recovery, and are not making the usual Indian mistake of rushing in at the top of the market. A more likely explanation is that the decent returns over the past 12 months compared to what has been gained in alternatives such as bank deposits, real estate and gold have pulled money into the financial markets, and past returns have been cemented into expectations about the future.
Financial markets often begin to move up before an improvement in actual economic conditions. That is the nature of risk investment—to look ahead. The ability to take stronger bets on the future is strengthened when there is ample liquidity sloshing around. However, a sustainable market rally will eventually need to be supported by improved corporate earnings growth. The anticipated turn in the Indian earnings cycle has not yet materialized. Nor is corporate investment taking off at a time when companies prefer to use their cash flow to reduce their leverage rather than invest in new capacity.
The Indian markets have begun to look frothy now. The increased retail participation in the markets needs to be welcomed if one takes the long view. Indian households have generally not been able to profit from the growth in the Indian economy since 1991, preferring to park their money in fixed-income instruments. However, expectations are now running ahead of actual corporate performance—and it is time for investors to be a little more careful till there are clearer signs that the Indian corporate earnings cycle has turned.
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